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Tuesday, February 10, 2009

An Ode to ‘Failed Theories’

Last night El Presidente Obama gave a speech in which he referenced the “failed theories” that we have tried in the last 8 years. I wasn’t sure exactly what he was referring to. He does allude to de-regulation as the cause of much evil. But it seems he’s getting at something bigger when he says that.

So what are these failed theories? He ridiculed those who advocate that we do nothing. Our president seems to like setting up strawman arguments. I had to wonder if he was talking about capitalism, free market economics, and limited government ideas. I think that’s what he’s getting at. He said that right now government is the only entity that can fill in the void at this time.

This is horrifying to me on many levels. The free market works because it is dependent on the millions of actions, priorities, and decisions made by individuals. People choose how they invest, spend, save, or work based on a number of factors. They tend to consider price, preferences, and make decisions how to allocate their scarce resources in their short-term and their long-term horizons. Some people work to make as much money as possible, others prefer fulfillment over money, some spend on the ballet, others on classic cars, stamps, or whatever else.

The free market simply gives people more leeway and a broader range of options than in a regulated or government directed economy.

What government planners tend to do is rely on microeconomic theories about behavior to try and incentivize people to engage in activities that the planners prefer. For example, a cigarette tax is intended to discourage smoking by making it relatively more expensive. Or, tax deductions on mortgage interest is intended to incentivize people to buy homes by making it relatively more cheap than would be the case if it were not deductible. If you have $10K in interest paid to the mortgage lender, you can write off the marginal tax you would have paid on that amount, which saves you anywhere from $1,000 to almost $4,000 depending on what you earn. If it there were not a mortage tax deduction you could argue that home prices would go down because people may bid a home to a degree anticipating that deduction.

The problem with government-planned economics is that it assumes the planners can make better value judgments about what people should do with their resources than people. But people should decided what they want to do with their resources based on how they value their time, prices/wages, preferences, etc.

Market economics is thought to have started with Adam Smith. But this is not the case. What Smith did was to formalize these ideas, analyze, and state them in his classic “Wealth of Nations”. He most clearly articulated how a market economy worked. That was his great achievement. But he did not invent it because a form of a free market existed in different societies for many centuries. It is how people relate in a society in which goods and services of all sorts are exchanged. It's level of freedom differs in different times and places. Smith explained why the freer the better. This still holds to be true.

There are times when a market fails to varying degrees. This often happens for a variety of reasons. In the current environment it happened to large extent because of housing. Home prices were bid up, there was an easy money policy, which kept interest rates low and allowed for a lower monthly home payment, and there were mortgage related securities with questionable valuations. In this case, government – both the Federal Reserve and the Fannie Mae and Mac – intervened incorrectly. Planners planned wrong and incentivized behavior that would ordinarily not have been encouraged.

So now we want to add more government because of the record of “failed theories.” This is an error in both the diagnosis and the recommendation. America is in for a decade-wide depression directly attributable to the specific policies that have been advocated starting in September of 2008 and accelerating at this moment. This nation has a decision to make. I am not encouraged by where we’re going.